IRS and Treasury Department Issue Final Rules on Transfers of Clean Energy Tax Credits

On April 25, 2024, the Internal Revenue Service (IRS) and the Treasury Department issued final regulations (the Final Regulations) for energy tax credit transfers under Section 6418 of the Internal Revenue Code (the Code). Section 6418 was added to the Code as part of the Inflation Reduction Act of 2022 (the IRA) and allows certain eligible taxpayers to elect to transfer certain clean energy tax credits to unrelated taxpayers for cash rather than use the credits to offset their U.S. federal income tax liability. The addition of Section 6418 to the Code has allowed taxpayers to monetize clean energy tax credits, spurred investment in the energy sector, and created a marketplace for tax credit transfers.

Prior to the enactment of the IRA, clean energy tax credits only could be used by taxpayers that owned the underlying clean energy projects generating such credits. As a result, third-party investment in clean energy projects traditionally was accomplished through complex tax equity structures generally only available to large-scale projects and sponsored by large financial institutions. During the consideration of the IRA, members of Congress had voiced concerns that the tax equity market was insufficient to adequately support the adoption of clean energy technologies at the pace they felt necessary. To address these concerns, Congressman Blumenauer introduced an early version of these provisions during the 116th Congress, H.R. 2704. A similar mechanism was later highlighted in President Biden’s American Jobs Plan, forming the basis of legislation that ultimately became the IRA.

Transferability of these clean energy credits significantly furthers the goals of the IRA because it has created a market for clean energy tax credits with increased participants, and the traditional tax equity structure is no longer needed to monetize the clean energy tax credits. Rather, any developer that generates eligible tax credits can sell those credits in the open market for cash, which can provide the funding needed to finance other clean energy projects. As of early March, Treasury reported that more than 45,000 projects requested a registration number needed to transfer a clean energy credit.

Overview of Section 6418

Section 6418(a) allows an eligible taxpayer to elect to transfer to an unrelated taxpayer all or a portion of an eligible credit. An “eligible taxpayer” is any taxpayer that is not a tax-exempt organization, state, political subdivision, Indian Tribal government, Alaska Native Corporation, rural electricity cooperative, or the Tennessee Valley Authority (i.e., generally persons and entities subject to tax under the Code; these other entities, however, may benefit from the direct pay mechanism at Section 6417, which is beyond the scope of this Advisory).

If an eligible taxpayer (the transferor) makes an election to transfer all or a portion of a credit (a transfer election), the taxpayer to whom the credit is transferred (the transferee) is treated as the taxpayer for U.S. federal income tax purposes and allowed to utilize the transferred credit to offset its own U.S. federal income tax liability. Under Section 6418(b), any consideration for the tax credit by the transferee to the transferor must be paid in cash and is neither includable in the transferor's gross income nor deductible by the transferee.

If a partnership or S corporation makes a transfer election with respect to property or a facility held directly by such partnership or S corporation, any consideration for such transfer is treated as tax-exempt income, and a partner’s distributive share of such tax-exempt income is based on such partner’s distributive share of the otherwise eligible credit for each taxable year.

The following eleven tax credits are eligible to be transferred under Section 6418:

• Alternative fuel vehicle refueling property (Section 30C)
• Renewable electricity production (the Production Tax Credit under Section 45)
• Carbon oxide sequestration (Section 45Q)
• Zero-emission nuclear power production (Section 45U)
• Clean hydrogen production (Section 45V)
• Advanced manufacturing production (Section 45X)
• Clean electricity production (Section 45Y)
• Clean fuel production (Section 45Z)
• Energy investment (the Investment Tax Credit under Section 48)
• Qualifying advanced energy projects (Section 48C)
• Clean electricity investment (Section 48E)

Under Section 6418(e), a transfer election is irrevocable, and a credit can only be transferred once. A transferor must make a transfer election on its original tax return for the taxable year for which the credit is determined by the due date of such return (including extensions), and the transferee taxpayer takes the transferred eligible credit into account in its first taxable year ending with, or after, the transferor’s taxable year with respect to which the transferred eligible credit was determined.

Under Section 6418(g), if the IRS determines that there is an “excessive credit transfer” to a transferee, then the tax imposed on the transferee is increased in the year of such determination by the amount of such excessive credit transfer plus 20%, unless the transferee demonstrates that the excessive credit transfer resulted from reasonable cause. In its “General Explanation of Tax Legislation Enacted in the 117th Congress,” the Joint Committee on Taxation noted that a technical correction — a legislative fix — may be necessary to clarify the timing of the tax increase for an excessive payment. An excessive credit transfer is defined, with respect to a facility or property for which a transfer election is made for any taxable year, as an amount equal to the excess of (1) the amount of the eligible credit claimed by the transferee with respect to such facility or property for such taxable year over (2) the amount of the eligible credit that, without application of Section 6418, would be otherwise allowable under the Code with respect to such facility or property for such taxable year.

Summary of the Final Regulations

The Final Regulations follow the issuance of proposed regulations on June 14, 2023 (the Proposed Regulations) and a subsequent review and comment period. The Final Regulations generally adopt the rules set forth in the Proposed Regulations, with some additional clarifications. The Final Regulations describe rules for making transfer elections, including definitions and special rules applicable to partnerships and S corporations and regarding excessive credit transfer or recapture events. In addition, the Final Regulations describe rules related to a required IRS pre-filing registration process. The following discussion provides a summary of the key points from the Final Regulations.

General Rules and Definitions

• Partnerships and entities with tax-exempt partners may qualify as transferors. A partnership with one or more tax-exempt partners is entitled to make a transfer election with respect to a property or facility held directly by the partnership; however, the limitations under Sections 50(b)(3) and 50(b)(4) for property used by tax-exempt entities may limit the amount of eligible investment tax credits determined with respect to any tax-exempt or government entity partner.
• Energy storage technology is eligible credit property. A transferor may make a transfer election to transfer any specified portion of an eligible credit determined with respect to any eligible credit property of the transferor for any taxable year. The Final Regulations base the definition of an “eligible credit property” on the underlying Code provisions for the eligible credits. However, there was some confusion in the Proposed Regulations as to whether energy property qualifying as energy storage technology under Section 48(c)(6)(A) would be eligible credits that could be transferred under Section 6418. The preamble to the Final Regulations (the Preamble) clarifies that, to the extent a Section 48 credit is determined with respect to energy property held by a transferor, whether the credit is with respect to energy storage technology or other energy property, such credit is an eligible credit that can be transferred under Section 6418 by the transferor.
• Revised definition of eligible credit property for purposes of Section 45Q. Because Section 45Q (carbon sequestration credit) does not require a taxpayer to own every component of a single process train, the Final Regulations do not require a taxpayer to own every component of a single process train with respect to carbon capture property for it to be eligible credit property.
• Bonus credit amounts cannot be transferred separately; only “vertical” transfers are allowed. Each eligible credit determined with respect to a single eligible credit property is a single eligible credit that cannot be separated into a base credit amount and bonus credit amounts (such as bonus credits for satisfying prevailing wage and apprenticeship requirements) for purposes of making transfer elections. Although commenters suggested allowing “horizontal” transfers of eligible credits, the IRS viewed allowing horizontal credit transfers as administratively burdensome due to the need for taxpayers and the IRS to track all base and bonus credit amounts separately. Instead, a transferor can transfer the entire eligible credit (or portion of the entire eligible credit, which would include a proportionate amount of any component bonus credit amounts taken into account to determine the entire eligible credit) determined with respect to a single eligible credit property (i.e., a “vertical” credit transfer).
• No secondary transfers of eligible credits are allowed. Consistent with Section 6418(c)(2), the Final Regulations provide that a specified credit portion may only be transferred pursuant to a transfer election once, despite several commenters’ advocating to allow transfers to brokers and a liquid trading market.
• Cash payments cannot be made in advance. The Proposed Regulations provided that cash payments can be made within the period beginning on the first day of the transferor’s taxable year during which a specified credit portion is determined and ending on the due date for completing a transfer election statement (generally the taxpayer’s due date for filing their tax return). Commenters requested revising this rule so that advanced payments could be made for eligible credits that will be determined in later taxable years. The Preamble indicates that allowing advanced payments would also raise several complex legal and administrative issues. For this reason, the Final Regulations do not adopt a rule allowing advance payments for transfer elections.
• Transferors may transfer to multiple transferees. The Preamble confirms that a transferor may transfer all or a portion of an eligible credit to more than one transferee subject to the limitation that such portions, in the aggregate, cannot exceed the amount of the determined eligible credit.
• Grantor trusts can make transfer elections. If a transferor is a grantor or any other person that is treated as the owner of any portion of a trust as described in Section 671 of the Code, then such transferor may make a transfer election for any eligible credits determined with respect to eligible credit property held directly by the portion of the trust that the transferor is treated as owning under the grantor trust rules.
• No transfer election is allowed if eligible credits not determined with respect to taxpayer. No transfer election is allowed for eligible credits that are not determined with respect to a transferor. For example, a Section 45Q credit allowable to a taxpayer because of an election made to allow the person that disposes of the qualified carbon oxide, utilizes the qualified carbon oxide, or uses the qualified carbon oxide as a tertiary injectant to claim such Section 45Q credit, is not an eligible credit that can be transferred by the taxpayer because such credit is not determined with respect to the taxpayer.
• Transferors must make a transfer election to transfer a specified credit portion on the basis of a single eligible credit property. The Final Regulations also include special rules for eligible credits under Sections 45, 45Q, 45V, or 45Y providing that an election is made (1) separately with respect to each facility for which a credit is determined and (2) for each taxable year during the 10-year period beginning on the date such facility was originally placed in service (or, in the case of a Section 45Q credit, for each taxable year during the 12-year period beginning on the date the single process train of carbon capture equipment was originally placed in service).

Manner and Method for Making a Valid Transfer Election

• Rules for making a valid transfer election. To make a valid transfer election, a transferor, as part of filing an annual tax return (or short period return), must include the following: (1) a properly completed relevant source credit form for the eligible credit for the taxable year that the eligible credit was determined; (2) a properly completed IRS Form 3800, General Business Credit; (3) a schedule attached to the IRS Form 3800 showing the amount of eligible credit transferred for each eligible credit property, except as otherwise provided in guidance; (4) a transfer election statement; and (5) any other information related to the election specified in guidance.
• Initial transfer election can’t be made on an amended tax return. The Proposed Regulations provided that a transfer election must be made on an original return not later than the due date (including extensions) for the original return of the transferor for the taxable year for which the eligible credit is determined and that no transfer election could be made or revised on an amended return. The Preamble to the Proposed Regulations provided that transferors could make a transfer election on a “superseding return” up until the extended due date for the return. Despite commentators’ request to allow taxpayers to make transfer elections on amended tax returns, the Final Regulations clarify that a transfer election only can be made on an original tax return or a superseding return filed on or prior to the extended due date for the return, and cannot be made for the first time on an amended tax return. The Final Regulations do, however, allow a transferor to file an amended return (after making a timely and complete transfer election) to adjust the amount of the eligible credit reported on the original return.
• Automatic six-month extension granted for making a transfer election. The Final Regulations allow for an automatic six-month extension of time from the due date of the return (excluding extensions) to make a transfer election.
• Broad form of transfer election statement adopted. The Final Regulations broadly provide that any document, including a partnership agreement, can be used as a transfer election statement if it contains the requisite information and representations of both the transferee and transferor. A transfer election statement can be completed at any time after the transferor and transferee taxpayer have sufficient information to meet the requirements of the Final Regulations, but not before the earlier of (1) the filing of the transferor’s return for the taxable year for which the specified credit portion is determined with respect to the eligible credit or (2) the filing of the transferee’s return for the year in which the specified credit portion is taken into account. The statement must be labeled as a “transfer election statement” and attached to the tax returns of both the transferor and transferee.
• No increase to the amount of required minimum documentation that a transferor must provide to a transferee to make a valid transfer election. Several commenters requested that the Final Regulations adopt robust minimum documentation requirements that a transferor must provide a transferee, including specific disclosure requirements and documentation concerning compliance with labor laws. The Final Regulations reject this request, but the Preamble provides that any particular agreement between a transferor and transferee may go beyond the required minimum documentation based on the arrangement of the parties.

Rules for Transferees and Transferors

• Additional clarity is provided for 52-53-week taxable years. The Final Regulations clarify that for purposes of determining the taxable year in which a credit is taken into account, a 52-53-week taxable year of a transferor or transferee is deemed to end on or close on the last day of the calendar month nearest to the last day of the 52-53-week taxable year, as the case may be. Thus, in cases where the transferor and transferee have different tax years, the transferee and the transferor would have the same year end, and the transferee would not have to wait until the following year-end to take the eligible credit into account.
• The passive credit rules apply to transferred specified credit portions. A specified credit portion transferred to a transferee is treated as determined in connection with the conduct of a trade or business and, if applicable, such transferred specified credit portion is subject to the rules in Section 469 (passive credit rules). The Preamble confirms that, if an individual transferee taxpayer does not materially participate in the activity that generates a specified credit portion, a transferred specified credit portion will be treated to the transferee taxpayer as arising in connection with a passive activity. Thus, an individual transferee taxpayer can use eligible credits acquired as a result of a transfer election to offset passive income tax liability.
• Transferee may take tax credits into account when calculating estimated tax payments. The Proposed Regulations explained that a transferee could take into account a specified credit portion that it has purchased, or “intends to purchase,” to calculate its estimated tax payments. Commenters requested clarification of the phrase “intends to purchase.” The Final Regulations clarify that such phrase captures a situation in which the taxpayer plans to complete a transaction that would qualify the taxpayer as a transferee taxpayer with respect to a specified credit portion, but has not yet done so. As such, all the requirements of a transfer election do not have to be met for a transferee to take the expected eligible credit into account in its estimated tax calculations, though the transferee remains liable to the extent the transferee has an underpayment of estimated tax if the eligible credit is not obtained as expected.

Transfers Involving Partnerships and S Corporations

• The Final Regulations provide a special rule for allocations of tax-exempt income and eligible credits resulting from a transfer of a specified credit portion of less than all eligible credits determined with respect to an eligible credit property held by a transferor partnership. This special rule permits tax-exempt income resulting from the receipt of consideration for a transfer of one or more specified credit portion(s) of less than all eligible credits from an eligible credit property to, generally, be allocated to those partners that desired to transfer their distributive share of the underlying credits. To take advantage of this special rule, a transferor partnership first determines each partner's distributive share of the otherwise eligible credits determined with respect to such eligible credit property (a partner’s “eligible credit amount”). Then, the transferor partnership determines, either in a manner described in the partnership agreement or as the partners may agree, the portion of each partner's eligible credit amount to be transferred and the portion of each partner’s eligible credit amount to be retained and allocated to such partner. Following the transfer of the specified credit portion(s), the transferor partnership is permitted to allocate to each partner its agreed upon share of eligible credits, tax-exempt income resulting from the receipt of consideration for the transferred specified credit portion(s), or both, as the case may be; provided that, the amount of eligible credits allocated to each partner do not exceed such partner’s eligible credit amount and the amount of tax-exempt income allocated to each partner equal such partner’s proportionate share of tax-exempt income resulting from the transfer(s). Each partner’s proportionate share of tax-exempt income resulting from the transfer(s) is equal to the total tax-exempt income resulting from the transfer(s) of the specified credit portion(s) multiplied by a fraction (1) the numerator of which is a partner’s total eligible credit amount minus the amount of eligible credits actually allocated to the partner with respect to the eligible credit property for the taxable year and (2) the denominator of which is the total amount of the specified credit portion(s) transferred by the partnership with respect to the eligible credit property for the taxable year.
• In the case of an eligible credit property held directly by a partnership or an S corporation, no transfer election by any partner or S corporation shareholder is allowed. The language in Section 6418(c) requiring an eligible credit property to be “held directly” by a transferor partnership or transferor S corporation allows for such eligible credit property to be owned by an entity disregarded as separate from the transferor partnership or transferor S corporation for U.S. federal income tax purposes.
• Application of passive activity rules to partnerships and S corporations. Any tax-exempt income resulting from the receipt of consideration for the transfer of a specified credit portion by a transferor partnership or transferor S corporation is treated as arising from an investment activity and not from the conduct of a trade or business within the meaning of Section 469(c)(1)(A). Additionally, any tax-exempt income is not treated as passive income to any direct or indirect partners or shareholders who do not materially participate within the meaning of Section 469(c)(1)(B).
• No recapture on sale of partnership interests of S corporation interests. The disposition of a partner’s interest or of an S corporation shareholder’s interest in a transferor partnership or an S corporation, respectively, does not result in recapture for which a transferee is liable.

Additional Information and Registration

• The Final Regulations provide an overview of the pre-filing registration process. Section 6418(g)(1) provides that as a condition of, and prior to, any transfer of any portion of an eligible credit under Section 6418, the IRS may require such information or registration as it deems necessary for purposes of preventing duplication, fraud, improper payments, or excessive payments under this section. The Final Regulations specify these pre-filing registration requirements, including: (1) manner of pre-filing registration; (2) pre-filing registration and election for members of a consolidated group; (3) timing of pre-filing registration; (4) that each eligible credit property must have its own registration number; and (5) information required to complete the pre-filing registration process. The Final Regulations also provide rules relating to the registration number, including: (1) general rules; (2) that the registration number is valid for only one taxable year; (3) renewing registration numbers; (4) amendment of previously submitted registration information if a change occurs before the registration number is used; and (5) that the registration number is required to be reported by a transferor and transferee.
• The Final Regulations do not address the tax treatment of transaction costs such as legal and consulting fees, success-based fees, tax insurance, and indemnity payments. The IRS indicated that the treatment of such costs generally is governed by other provisions of the Code, but the application of other Code provisions to determine such treatment may involve the relation-back of such costs to the credit transfer transaction and its general characterization under Sections 6418(a) and 6418(b).

Special Rules

• Tax credit recapture risk is to be borne by the transferee. Despite several commenters recommending that the risk of tax credit recapture be allocated to the transferor, the Preamble confirms that such risk should be borne by the transferee with respect to its specified credit portion for all types of recapture events, consistent with the statutory framework for recapture under other tax credit schemes. The Final Regulations clarify that (except in the case of a partner or S corporation shareholder subject to special rules) recapture liability applies proportionately to the transferee and transferor to the extent a transferor has retained eligible credits determined with respect to the relevant eligible credit property, and provide formulas for determining the recapture allocation in such scenarios.
• No relief for ineffective transfer elections. The IRS declined to adopt a rule providing for reasonable cause relief in the event of an ineffective transfer election. Rather, the Final Regulations state that an ineffective transfer election means that no transfer of an eligible credit has occurred for purposes of Section 6418, and the tax consequences are determined under any other relevant provisions of the Code.
• The Final Regulations address uncertainty surrounding REITs that may be continuously earning and selling eligible credits. First, the Final Regulations provide that eligible credits that have not yet been transferred pursuant to Section 6418 are disregarded for purposes of the REIT Asset Test. Second, the Final Regulations provide that the transfer of a credit is not a sale of property for purposes of Sections 857(b)(6)(C)(iii) and 857(b)(6)(D)(iv) and, thus, does not count as one of the seven sales described in those provisions. The Preamble confirms that the receipt of a credit does not result in gross income to a REIT, but the Final Regulations do not adopt a specific rule in this regard.
• Transferees may carry forward unused credit amount. A transferee can apply the rules in Section 39(a)(4) (regarding the carryback and carryforward period for applicable credits) to a specified credit portion to the extent the specified credit portion is described in Section 6417(b) (list of applicable credits, taking into account any placed in service requirements in Sections 6417(b)(2), 6417(b)(3), and 6417(b)(5)).

Conclusion

Section 6418 was effective for taxable years beginning after December 31, 2022, and the Final Regulations are effective beginning July 1, 2024. The issuance of the Final Regulations will provide taxpayers additional certainty as the market for clean energy tax credit transfers continues to grow. Congress remains closely interested in the performance of this new tax payment mechanism. Should it prove successful over the long term, it is possible that Congress may expand eligibility to other tax credits.

© Arnold & Porter Kaye Scholer LLP 2024 All Rights Reserved. This Advisory is intended to be a general summary of the law and does not constitute legal advice. You should consult with counsel to determine applicable legal requirements in a specific fact situation.